People planning for retirement need to consider several risks. One is longevity risk, which is the risk of living longer than expected and potentially out living assets. Another is withdrawal risk, which is the risk that the retiree's rate of savings withdrawal is unsustainable and will completely deplete the savings before death. The third is inflation risk, where the purchasing power of the assets is reduced due to inflation. Finally, there is also the sequence of returns risk, which is the risk of poor market performance in the early years of retirement. Collectively, these risks could impact retirement outcome. Fortunately, a variety of investment vehicles exist in order to mitigate these risks.
One investment vehicle that some may use in retirement is common stock, which has the potential to produce high returns. Unfortunately, these returns can also be volatile, and losses due to stock volatility may severely impact retirement savings. Alternatively, investments in cash equivalents are far less volatile, but yields may be unacceptably low. An asset allocation made up of traditional assets, such as stocks, bonds, real estate, cash equivalents and other asset classes, may therefore be desirable for some investors to minimize volatility while maintaining acceptable returns. Model portfolios may be created by research departments of financial institutions to achieve a desired return for a given risk tolerance. Model portfolios are mostly created based on a risk return profile. For example, a conservative portfolio might include 65% bonds and 35% equities, and an aggressive portfolio might include 20% bonds and 80% equities. One who is skilled in the art will understand and appreciate that allocations of the portfolios can be changed based on various market forces and/or customer desires.
Another type of asset that can be purchased for retirement is an annuity. Annuities are available in many forms, e.g., deferred variable annuities, deferred fixed annuities, deferred income annuities, variable immediate annuities and fixed immediate annuities. A fixed immediate annuity is a well-known financial vehicle offered by insurance companies that is used to pay a person a certain sum of money in a series of distributions made at regular intervals, typically monthly or annually starting at a given date, based on a given amount of principal from an initial contribution of assets, commonly known as premium. Income annuities are available in many forms. The distributions may be made for a predetermined definite period, as in an annuity certain, or for as long as the person lives, as in a life annuity. Payments under a life annuity may terminate on the annuitant's death, as in a straight life annuity, or may continue to a beneficiary for a specified period after the annuitant's death, as in a life annuity with period certain. Alternatively, a life annuity may be based on two lives jointly, as in a joint and last-survivor annuity in which payments continue to be made to the survivor for the remainder of his or her life. The payments under an income annuity may be set to begin one payment interval after purchase of the annuity, as in an immediate income annuity, or after a specified amount of time, as in a deferred income annuity.
It is difficult, however, for retirees to determine what mix of asset classes, and in what proportion, will produce desired retirement objectives. In addition, investors may also have competing desires for their retirement assets. One such desire could be the legacy potential of the assets, which is the ability to leave assets to heirs, after the retiree's death. Another such desire is liquidity potential, including the ability to withdraw as cash or to convert to cash all or a large portion of the assets on relatively short notice, such as in the event of a medical emergency. Therefore, it can be important that the assets not be locked up in a financial vehicle that makes them inaccessible or illiquid. Simply using traditional assets via model portfolios may not adequately address all retirement risks, and the problem becomes even more difficult should the investor desire to allocate retirement assets among not only traditional assets, but also non-traditional assets or products, such as annuities.
Traditional asset allocations are constructed based on the modern portfolio theory (“MPT”) developed by Harry Markowitz and William Sharpe. See Markowitz, Harry “Portfolio Selection,” Journal of Finance, September 1952, pp. 77-91; and Sharpe, William “Capital Asset Prices: A Theory of Market Equilibrium,” Journal of Finance, September 1964. MPT selects optimal portfolio allocations based on the investor's risk tolerance. Essentially, it is a mean-variance optimization. MPT is widely accepted in the academic and the finance industry as the primary tool for developing asset allocations. However, because MPT expresses an investor's preference between risk and expected return, it lacks consideration of retirement risk factors.
Consideration of an investor's desire outside of risk tolerance and expected return are not adequately addressed in existing portfolio allocation offerings. Present systems operate according to the MPT, and allocate assets among investments based on the investor's risk tolerance. Unfortunately, these systems do not consider retirement risks, such as likelihood of running out of money, legacy and/or liquidity desires. Therefore, there exists a need for an improved investment portfolio allocation system and method.